Don't Let Roth IRA Income Limits Ruin Your Retirement


A Roth IRA can give you the perfect opportunity to optimize your retirement savings strategy. But if you make too much money, then the IRS may not allow you to take advantage of that opportunity. These high-income taxpayers raise an obvious question: Is there any way around the Roth IRA income limits that the tax laws impose?

For many, the answer is yes. I'll explain in detail later in this article, but first, let's take a look at the income limits themselves and what exactly they stop you from doing.

Keeping a bottle on the Roth
IRAs have been around for a long time, but Roth IRAs are relatively new, having first become available just 15 years ago. When they were introduced in 1997, they were intended to give an additional incentive for people to save for retirement. In contrast to the way regular IRAs work, Roth IRAs don't give you an up-front tax deduction, but they provide completely tax-free growth and don't create tax liability when you withdraw your money in retirement.

But to prevent high-income taxpayers from using Roth IRAs to shelter huge amounts of retirement savings from tax for decades, Congress put limits on the ability for people to contribute to Roths. Specifically, if you file as a single person and make more than $125,000 in adjusted gross income for 2012, you're not eligible to contribute to a Roth at all. The corresponding figure for joint filers is $183,000. Moreover, even below those amounts, you're only entitled to a partial contribution if you make more than $110,000 as a single filer or $173,000 as a joint filer.

The sneaky way into a Roth
Still, there's a way for many high-income taxpayers to get into a Roth. It takes a bit more work, but it can lead to the same result.

Everyone is allowed to contribute to a traditional IRA, no matter how much money they make. The only question is whether you can deduct that contribution. If you aren't eligible to participate in a retirement plan like a 401(k) at work, then you can put money in a deductible IRA no matter how much you make.

So the strategy goes like this: Contribute to a regular IRA but then turn around and convert that IRA to a Roth. Because Congress took away the income limits for Roth conversions back in 2010, you can do that -- and if you do, then the added taxable income from the conversion will exactly offset the deduction from the regular IRA contribution, leaving you in exactly the same position you would've been in if you'd been allowed to contribute directly to a Roth.

Why it's worth the effort
That may seem like a lot to go through just to get money into a Roth. But consider the benefits:

  • Having a Roth means never having to worry about what tax rates will apply in future years. With the current fiscal cliff, that certainty is worth more than ever.

  • In particular, keeping certain stocks in a Roth has huge advantages over keeping them in taxable accounts. The obvious examples are mortgage REITs Annaly Capital (NYS: NLY) , Chimera Investment (NYS: CIM) , and American Capital Agency (NAS: AGNC) , each of which yields well over 10%. With effective tax rates on their dividends set to move above 40% in 2013, the value of tax-free treatment will increase dramatically. The same is true for rural telecom stocks Frontier Communications (NAS: FTR) and Windstream (NAS: WIN) , both of which stand to lose preferential 15% maximum tax rates on their dividends if current tax laws are allowed to expire.

  • In retirement, Roth distributions don't add to your taxable income. That has huge implications for many things, including eligibility for benefits as well as taxation of Social Security and other income.

So if you've never looked at a Roth IRA because you figured that the income limits governing them were too strict, don't give up. With a little effort, having your own Roth could be just a few steps away.

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Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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